January 28, 2009

A Regulatory Lesson for the Future

This week the world’s most powerful leaders meet in Davos, Switzerland for the World Economic Forum. As an indication of the changing times, this year’s summit will be attended by 40 heads of state, as compared to only 27 last year. More regulation lies ahead and undoubtedly there needs to be a balance between purposeful, tough regulation and free-market oriented solutions. However, more should not be a synonym for effective when it comes to regulation. This can only be achieved if the financial institutions that have fallen victim to the current crisis are willing to assist regulators and come to terms with the notion that there may be a change in regulatory arbitrage and the world financial system as a whole.
A well-documented but relatively unknown regulatory change in 2004 serves as both a prime example of ineffective regulation and as a “what not to do” lesson for future regulatory efforts. In 2004 the SEC unveiled the “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities”. Only half-jokingly, conspiracy theorists may find some truth in the SEC along with the former investment banks purposely devising this overly mundane title in order to divert any scrutiny. Do not be fooled by the seemingly unimpressive and insignificant title of this regulation, however. This net capital rule altered the capital requirements that the former investment banks (Bear Stearns, Morgan Stanley, Lehman Brothers, Goldman Sachs and Merrill Lynch) had to abide by. Under the existing rules, broker-dealers had to maintain a 15 to 1 debt to net capital ratio. The 2004 alternative net capital rule relaxed capital requirements and allowed the use of the now notorious value-at-risk models to assess capital positions. Furthermore, the new regulation expanded the qualifications for net capital. Even the SEC admitted that, “inclusion in net capital of unsecured receivables and securities that do not have a ready market under the current net capital rule will reduce the liquidity standards…” And how did all of these now illiquid assets go undetected for so long? Well, “We [the SEC] are amending the definition of tentative net capital to include securities for which there is no ready market.”
The rationale for this regulation was two-fold. On the one hand, the investment banks, or Consolidated Supervised Entities (CSEs), were taking advantage of the E.U.’s 2002 Financial Conglomerates Directive. The E.U. directive was designed to impose regulation of parent companies whose subsidiaries were regulated financial institutions operating in the E.U. However, the directive contained an exemption for foreign-based parent companies if the company in question was subject to “equivalent” regulation in its home country. Thus, in order to avoid heavy regulation by the E.U. the U.S.-based investment banks, who performed a substantial amount of business in the E.U., lobbied the SEC to regulate them. For the SEC’s part, this was the perfect opportunity to govern the murky world of investment banks. In return for more lenient net capital rules, the investment banks agreed to partake in the CSE program and offer the SEC information on business operations and risk models. Think of the movie Scarface, in which upon being arrested by the police (who represent the SEC) for money laundering, Tony Montana (who represents the CSEs) replies, “I’m here changing dollar bills is all.”
So we now enter a new paradigm, at least for the near future, in which investors and money will flow towards, not away from, regulation. If this financial crisis has proven one thing, it is that the debate over rules-based vs. principles-based regulation is a moot point. Both forms of regulation were implemented and both failed. Historically, money has tended to flow away from regulation, but it is now quite possible that the nations with the most effective regulatory systems will see an influx of capital relative to those nations with futile financial regulation.
The coming months may well determine the future of world financial markets. Governments’ tendencies will most certainly be towards more regulation, and rightly so. As the SEC’s 2004 attempt at regulation demonstrates, however, increased regulatory efforts must not be haphazard and should not be implemented simply for the sake of doing something. World regulators will have to communicate so as to avoid the mistakes that resulted from the E.U. and SEC regulations outlined above. Effective regulation can and should be achieved by proactive efforts on behalf of financial institutions, motivated by a desire to increase profits and simultaneously ensure the stability of the financial system.

Related

Today the Senate passed its version of the stimulus bill. The House version of the American Recovery and Reinvestment Act has a price tag of about $820 billion while the Senate version stands at a total of $838 billion. Now the two versions will have to be reconciled and signed by President Obama. The ultimate goal of the stimulus legislation is to restore demand by replacing private spending with public spending and using tax cuts to hopefully restore consumers’ income enough to spur consumption. It is widely accepted that a stimulus bill is the proper means by which to improve the economy – it is perhaps the best of some bad options.

During the presidential election the domestic policy of most concern to voters, other than the economy, was healthcare. President Obama ran on a campaign of implementing sweeping healthcare reform aimed at improving both efficiency and access. House Majority Whip James Clyburn has been quoted as saying it is better for reform to occur, “incrementally, than to go out and just bite something you can’t chew,” to which Speaker Pelosi had to rebut. While the current financial crisis may offer an opportunity to move towards universal coverage and an overhaul of the U.S. healthcare system, it is more likely that Obama’s first term (at least the first fiscal year) will be witness to incremental reform.